Pairs trading, initially developed by Morgan Stanley back in the 1980’s, the name of the chap eludes me currently, however, it proved very successful for a period of time. Like any profitable system, once the secret was out, imitation and competition dulled the returns.
Pairs trading however is still with us. Pairs that can show correlation that I’m aware of [on a daytrading timescale] are XOM/CVX, FNM/FRE, WMT/TGT, BNI/UNP/NSC, GLD/GDX
Obviously there are many others. Quantitative analysis of pairs are offered as a service;
Impactopia is a set of analytic tools dedicated to unravel relationships between financial instruments.
Every day, thousands of securities are traded in various markets around the world. We have developed an engine which allows traders to visualize/analyze the fluctuations of the financial markets. This site features this application on US equities.
Due to fundamental relationships between companies, to the propagation of information and to subtle connections between traders, some correlations between stocks exist. If a stock is negatively influenced by some announcement, what is the scenario for other stocks in the same sector? The engine we developed emphasizes the relevant correlations which connect the equities.
We consider here about 4,500 US equities traded on the NYSE, AMEX, and Nasdaq markets. In order to compare the price fluctuations of those equities, we compute the correlations for all possible pairs, i.e. about 10 million pairs. The engine developed by Impactopia helps sorting out the millions of correlation coefficients. A user can query the database for calculating lists of top correlated pairs of stocks, lists of anticorrelated pairs, and lists of correlated stocks to any equity.
In addition, a procedure selects the highest coefficients for placing them in a connected graph which is a tree. Such a tree represents the skeleton of the price fluctuations relationships in the market. Traders can learn a lot from such trees. The market leaders are always placed in the center of the tree, and sectors leaders have many strongly connected neighbors. Several sectors emerge out of the statistical analysis, they are clusters/branches of the tree. Nearest neighbors of an equity have a high probability to belong to the same sector.
Found here; http://www.market-topology.com/
Pairs trading has a drawback. Should the correlation breakdown for whatever reason, both trades can move against you. Thus we have a situation where, profits are reduced, losses potentially doubled and position management problems are doubled.
The advantage, like any hedged position, trying to guess, predict, analysing market direction is immaterial, as we are concerned with the spread.
